Psychological influences often govern financial decisions. Such influences and biases justify the anomalies, such as a tremendous fall in the stock price or severe rises.
The area of study that proposes how biases and psychological influences affect the financial behaviour of practitioners and investors is known as behavioural finance.
Behavioural finance incorporates research and experiments to demonstrate how biases and emotions can be held responsible for share prices. It explains why investors do not always have self-control and are compelled to make decisions based on their biases instead of facts.
IIM L finance course on financial services and capital markets is available online and discusses these concepts in detail. This article will guide you on everything you need to know about behavioural finance.
Behavioural Finance vs. Mainstream Financial Theory
Behavioural finance assumes that individuals participating in financial transactions are irrational about their decisions. Rather, their decisions are psychologically influenced.
Financial decision-making depends on the mental and physical health of the investors. Their decision may be biased for several reasons. Behavioural finance studies allow a deep understanding of how human emotions influence investments, risks, payments, and personal debts.
On the other hand, mainstream financial theory assumes that individuals are devoid of human emotions, social relations, and the effects of culture. The mainstream financial theory also assumes that one can earn maximum profits through firms while the markets remain efficient.
These assumptions are countered by behavioural finance.
Some Concepts Related to Behavioural Finance
Five main concepts make up behavioural finance. They are as listed below:
Mental accounting is a concept in economics that deals with how humans decipher, categorise, and evaluate economic outcomes and how each affects their spending and investment behaviour patterns. This may sometimes lead to irrational decision-making.
“Herd instinct” is a phenomenon where the actions of others influence people who base their actions on the research done by other people. Similarly, in the field of investment, individuals often tend to imitate the financial behaviours of others.
In this phenomenon, decisions are made based on intense emotions such as fear, excitement, anxiety, or rage. Being overpowered by emotions causes individuals to make wrong investment decisions.
Anchoring is a phenomenon in behavioural finance in which an individual relies subconsciously on irrelevant information to fix a certain level for reference and make investment decisions based on the fixed reference point.
This refers to an individual’s tendency to make choices based on his overconfidence in his skill or knowledge.
Some Biases Explained by Behavioural Finance
Some biases and tendencies are important factors for properly analysing behavioural finance. They are discussed below:
Investors are often biased towards accepting information allied with a thought they believe in. This holds true when an investor does not even verify the correctness of the information.
This phenomenon stems from an investor's recent encounter with a particular investment, and when such experiences recur, they tend to instil biases in the minds of investors, leading them to believe that a past event is more likely to happen again.
This cognitive tendency can also be labelled as availability bias or recency bias.
Loss aversion refers to the phenomenon when investors are more concerned about the losses rather than the possibility of making a profit. To put it in simple terms, investors stress more on avoiding losses rather than making investment gains.
Familiarity bias occurs when investors tend to invest in what they are “familiar” with. Such investment options include investing in companies that are locally owned or domestic. This bias often restricts an investor’s exposure across different sectors and types of investments, which might otherwise be less prone to risk or offer more profit than the familiar options.
Behavioural finance has two assumptions — markets are inefficient, and humans are irrational. The characteristics and psychology of investors play a huge role in decision-making and determining the overall outcome of the market. Having a thorough understanding of behavioural finance can assist investors in making informed decisions.
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